The Recent Banking Crisis – Are Derivatives to Blame?

Q:Why the recent banking crisis?

A: The seeds of the banking and credit crisis were sown long ago in cheap credit over-availability. The average securities firm was leveraged 27 to 1 – that is, had borrowed 27 times its capital – in 2007. That unbelievable recklessness is unwinding too fast as financial stocks are now suffering from a crisis of confidence – not helped by their own apparent distrust of each other – which has led to sharp share price devaluations. This is paralysing the credit markets, which means that businesses cannot grow and jobs cannot be created.

Consolidation of banks is a good thing and a correction is long overdue. the speed of ‘deleveraging’ poses real risks to the economy. Shorting as such did not cause this problem although it might have accelerated it and possibly exacerbated the correction.

Leverage and speculation have risks to both the long and short debate. For me the really interesting thing, is how the debate has been made to focus on the apparently morally dubious and dangerous practice of some market participants shorting. The debate has not focused on the cause of this systemic banking collapse, which is the arbitrage of regulatory agencies, allowing banks massive asset leverage via vehicles that were classified AAA through insurance policies supplied by AIG (“it’s ok, this toxic waste piece of paper is insured by AIG- they’re AAA, therefore this paper is….”).

I will say that again:

the cause of this systemic banking collapse is the arbitrage of regulatory agencies, allowing banks massive asset leverage via vehicles that were classified AAA through insurance policies supplied by institutions like AIG.

Although it was the policy of banks lending vast amounts of money to people who could never possibly afford to pay it back is what got us in trouble in the first place, this does not mean that we should ignore the earnings multiplier effect that gearing can have. This is particularly true if you trade an index vehicle or fund. Gearing can increase the rate of return over and above the market return you could achieve simply by holding these instruments.

A change in market sentiment represents an opportunity for the astute trader. Unfortunately many do not recognise this opportunity until it is too late or they have been so shocked by the ferocity of the decline that they are paralysed into inactivity. The most important thing for a trader to realise is that the market is in a state of flux and no condition is permanent. Bear markets are followed by bull markets and vice versa. This is simply the natural order of markets. Make sure you are ready to capitalise on the next market phase.

Only one famous quote I can ever think of that emphasizes my relation to the markets was by Bruce Lee!

Be like water making its way through cracks. Do not be assertive, but adjust to the object, and you shall find a way round or through it. If nothing within you stays rigid, outward things will disclose themselves.

Empty your mind, be formless. Shapeless, like water. If you put water into a cup, it becomes the cup. You put water into a bottle and it becomes the bottle. You put it in a teapot it becomes the teapot. Now, water can flow or it can crash. Be water my friend.

Q:Is it possible a lot of fake derivatives have been sold and bought?

A: Derivatives aren’t fake. A derivative, is a contract. The contract might be honoured or not, although IT IS enforceable by law. – just like any other contract. I found it interesting to note, however, that when Japan crashed in 1990, a large number of forged ‘Certificates of Deposit’ turned up – where organised criminal gangs had secured multiple lines of credit on a single asset or on multiple fictitious assets. I would be far from surprised to discover that other similar large-scale criminal activity might be uncovered in the West… my hunch is that, for us, this might be prevalent in the context of credit card debt.

Basically a derivative is an agreement between two people to pay each other depending on a specific outcome. A rather flippant example might be an equine velocity derivative – I pay you £10 up front. You agree to pay me £100 if Credit Default Swap is first past the post at the 3:30 at Doncaster.

A better example to illustrate the potential problems follows. Let’s say you want to invest in gold. You could buy a 1kg gold bar – cost £10000. If the price rises to £20000, you can sell it and take your profit. Where has the money come from? It comes from the buyer who buys it from you. What happens if someone doesn’t have the money to buy it? Then you tell them to sod off and you find another buyer. With something like gold, there will always be someone to take it off your hands.

Now let’s extend this to a grossly simplified derivative. A wants to invest in gold, but chooses to do so with a derivative. He finds B who agrees to be his counterpart to the derivative. A pays B £10000. In return, B promises to pay the price of 1kg of gold, when either party chooses to end the agreement.

Let’s say the price of gold rises to £20k per kg. A asks B to terminate the contract, and to pay up £20k. In effect, A has had exactly the same effect as having bought gold. And B has had exactly the same effect as having sold some gold, and buying it back later.

But, there’s a problem. What if B goes bust. What good is B’s promise to A to pay £20k, if he doesn’t have £20k? And that is the fundamental problem of derivatives – counterparty risk. The person/company you trusted to pay out doesn’t pay out.

Some types of derivative, e.g. futures contracts (for oil, gold, etc…) are traded on an exchange. The exchange matches up people wishing to take part in derivatives contracts – the ‘sellers’ and ‘buyers’. However, although the exchange matches up participants – it actually takes on the agreements itself. So, if the exchange matches up A & B, in the example above – in actuality 2 contracts are created: A ‘buys’ from the exchange, and B ‘sells’ to the exchange. This means that the exchange takes responsibility for paying up the other side of a deal. As a result, the exchanges are absolutely fanatical about making sure you are good for the deal. They will insist on suitable credit checks, and sufficient cash as collateral being paid up front (and topped up if you make a loss). A derivative traded on an exchange (stock options, futures, etc.) has never failed to pay up – if one party went bust because they made a big loss, the exchange covered for them so that their counterparty didn’t lose out. The exchange may also publish a list of all transactions, and impose limits on how much risk an individual party may take. E.g. the futures exchanges limit any on one company from entering into oil contracts worth more than $2 billion.

The problem is that most derivatives are not traded on exchanges. They are private contracts drawn up between two people. As these are private, no one knows how much risk any one company is taking on. There is no independent audit checking the collateral is acceptable. It relies on each party to the contract keeping tabs on the other party, and prompting them to cough up additional collateral as and when required.